Sunday, August 8, 2010

What’s the logical split of responsibilities as between central banks and elected politicians?

Currently most elected political parties (quite rightly) decide on the split of GDP as between public and private sectors. Same goes for the allocation of public spending as between education, defence, health, etc. and the design and shape of the tax system.

But the way decisions are taken on question as to what stance a country takes on the reflation – deflation scale is currently messy. (I’m considering countries with their own currencies here, rather than common currency systems, like the Euro.)

Elected parties have the power to effect stimulus by borrowing and spending more, while central banks have the power to negate the latter decision (e.g. by altering interest rates, or expanding or reducing their quantitative easing programmes). This is a bit like two people controlling the speed of a car: one controlling the accelerator and the other the brakes. If they agree on vehicle speed, there is no problem. If they disagree, then more accelerator AND more brake are likely to be employed at the same time: a nonsense.

This tension exists at the moment in the U.K. in that the finance minister, George Osborne, is trying to be austere, while the Bank of England is talking about more quantitative easing.

This tension would disappear, or could be made to disappear, in a Modern Monetary Theory regime. That is, if there were no government borrowing, and the “reflation – deflation” stance was controlled just by regulating government income and expenditure, then the only decision to be made on the “reflation-deflation” question would be as to the scale of government net spending. The central bank could have that decision, (with a view to controlling inflation) while the elected political party would decide on the details mentioned in the opening paragraphs above.